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Sunday, 21 March 2010

So there seems to be a wave of optimism sweeping Dubai and its creditors of late. The Governor of the UAE Central Bank said that he thought that Dubai would not require any additional funds. A few days ago some bank officials in London were quoted as saying that they thought the talks between Dubai and its creditors were going well. The DFM has had a nice rally. Dubai sovereign CDS have traded off lowering the borrowing costs for all involved. Even the Nakheel sukuks have traded higher, up to $0.62 on the dollar, their highest in quite a while. This is all for the best as the final restructuring terms are due in a week or so. Dubai can use a little optimism.

Of course it probably pays to take this optimism with a grain of salt. I think it is possible that a deal will be worked out with the creditors of Dubai World at the holding company level. The creditors at that level are a syndicate of banks who have an interest in the preservation of their relationships in the Emirates and while Abu Dhabi may or may not be willing to pony up more funds they probably are willing to black list any banks that don’t play ball with the restructuring which probably means that the banks will play ball.

That said, I remain deeply sceptical of the outcome for at least the Nakheel bondholders. In my last post I said that at least some of the creditors of Dubai World and its subsidiaries will refuse what I think will be a coercive restructuring and try their luck with a liquidation. I made the case that the Nakheel Sukuk holders are by far in the worst position of any of the creditors and are also likely to press for liquidation. This is because the deal they are likely to get from Dubai will probably be the worst on offer precisely because they have the weakest position because their recovery rate is likely to be extremely low. To understand why it is necessary to have a look at a project called Dubai Waterfront.

For those of you who are not familiar with Dubai Waterfront it is the largest single real estate project undertaken by Nakheel. Keep in mind that Nakheel is the same company that has built several islands in the shape of palm trees and an archipelago in the shape of the world. So to say that the Dubai Waterfront is their largest project is saying something. It was meant to house 1.5 million people and to be twice the size of Hong Kong. As it turns out it today is a windblown abandoned construction site and much of its eventual land area remains under water as quite a lot of it was to be built in the Gulf like the Palm. Of course you don’t get this sense from the website. An article appeared recently in the excellent Abu Dhabi paper The National which does a pretty good job of illustrating just how serious things are for the Nakheel bondholders and I think deserves a closer look.

For starters look in paragraph two of the article. In it they say “Waterfront land valued at Dh7.6bn was used to secure three Islamic bonds issued by Nakheel with a total value of $5.25bn.” Hold on a second. Sure, 7.6 is more than 5.25 but these figures are in two difference currencies.7.6 billion AED is only 2 billion USD. So what you have is $5.25 billion in debt secured with $2 billion of assets. Uh oh. In America this is what is called an “underwater mortgage.” As it turns out they are underwater in more ways than one. The 2011 sukuk is secured by a 50 year lease on 61 million square feet of the Central Business District, the CBD is to be built on an island that has yet to be built so the trust asset is both literally and figuratively under water.

The article then goes on to describe the Dubai Waterfront as 65% of the land that Nakheel has under development. If we happen to take a quick look at the balance sheet of Nakheel which shows that “properties under development” account for AED 112 billion. So, 65% of that is 72.8 billion AED is an approximate valuation on the balance sheet of Nakheel of Dubai Waterfront related properties. Guess how much equity the firm has, AED 73 billion. If it’s touch and go for the bondholders it is lights out for the equity holders.

The article then goes on to describe certain fraudulent transactions whereby certain people for a “consulting fee” would agree to sell property to developers for below market rates. This seems a little funny to me because the value of that land has almost certainly fallen precipitously from whatever the earlier discount happened to be. Nonetheless, there can be little doubt that the shareholders of Nakheel, and ultimately the bondholder have gotten much less from the boom than perhaps they were entitled to. I like the practice in the Emirates of naming defendants by their initials. Anyone want to bet that the people being prosecuted are non-Emiratis? Anyone want to bet that the “consulting fees” paid to full blooded Emiratis were much higher and will go unprosecuted? You can never be sure because those issues will never see the light of day, but I think that’s the way to bet.

More interestingly is the tale of Omniyat. The real estate developer engaged in selling off plan real estate. Omniyat sold off plan real estate in the Waterfront development. It was quite successful and sold about 314 million AED worth of future apartments mostly to Russians. It then took 237 million AED and bought the land with it. Then it took another 101 million AED and spent it on marketing in order to bring in more buyers. How much got spent on building the apartments? Around 700,000 AED. I’m not sure how the contracts read but usually off plan real estate is sold on an instalment basis such that if a certain amount of construction is not completed the buyer need not pay any more. Something tells me that additional payments are unlikely to be made to Omniyat despite the fortune spent on marketing. I think this is kind of a microcosm of the whole of the Dubai Waterfront project.

I think the Omniyat experience is telling for the whole of the waterfront project and ultimately for Nakheel and perhaps even Dubai World. Omniyat paid the great majority of its funds to Nakheel to buy the land, which is essentially undeveloped desert at this point. Of the remainder it then spent virtually every last dirham on marketing in order to create the illusion of prosperity. I’m sure it’s offices are impressive. I’m sure it has ads on the sides of buses all over the world and ads for its luxury lifestyle apartments in glossy magazines catering to the international elite. What it does not have are any tangible assets that can be handed over to its creditors that approach anything remotely like what appears on the balance sheet.

I think Nakheel is Omniyat writ large. In 2005 the first parcels of land in the Waterfront sold out in a few days for 13 billion AED. Looking at the balance sheet we can see that here in the future Nakheel has little more than 500 million AED in cash and is owed 17 billion AED in receivables and prepayments which it is very unlikely to receive and at the same time owes 28 billion to suppliers. What happened to all that other money? It probably went into marketing, into fancy offices, and ultimately into the pockets of the connected Emiratis who worked there. What is the collateral for the bondholders? Nothing but a lot of undeveloped desert.

Thus I don’t understand the bull case for Nakheel or Dubai World. What is it going to take to actually develop this desert into actual sellable real estate the proceeds of such sales will be used to repay the bondholders? What will it take to actually create those crescent shaped islands that are on the balance sheet for billions of AED? It will take a massive infusion of additional capital to complete all these unfinished projects. Remember that what is currently underway is a negotiated write down of the previous creditors under extremely opaque circumstances. Given that, what is the likelihood that new creditors will appear to lend additional billions in order to ensure that the original creditors even get back the fraction of their principal which will be agreed by the end of the week?

If you ask me: zero. Something similar to what the Nakheel Sukuk holders will eventually get.

DUBAI WORLD, the troubled Gulf investment fund that owns the QE2 cruise liner and Cirque du Soleil dance troupe, is to ask its creditors for up to eight more years to pay back a $22 billion (£15 billion) debt mountain.

The crisis-hit investment empire, owned by the Dubai state, will promise its lenders it will be able to pay back all the money it owes if it can get the extension.

The debt restructuring proposals will be put to a seven-strong committee of the group’s senior creditors in Dubai this week.